The current euro crisis, and the next one

I've been reading some articles by Liselotte Palme and Thomas Fricke on the situation of the euro and the EU. (See references and links below.) In an analysis in the 21.05.2010 Profil, she makes an excellent observation. It was only a year or so ago that the mighty financial markets were begging the taxpayers of Europe and the US to bail them out of the disaster they themselves had created. Which both Europe and the US did.

Now those same financial markets, in the form of big banks and hedge funds, are attacking EU bonds and so far have coerced the EU into setting up a large, €750 million (euro) bailout fund for the bonds in which they were investing, and which some speculators were driving down by using derivatives to place bets on the fall of those bonds. In other words, the financial markets were getting another huge bailout to save their investments in public bonds which had now turned riskier - because some speculators made a bet that they would go down and created a self-fulfilling prophecy. This year, though, they weren't going through the motions of requesting nicely. They just hammered the EU into doing it by attacking their bonds.

This round of the conflict between democracy and the financial markets show even more clearly than did the 2008 collapse and the resulting bailouts that there is a real conflict. To protect the interests of their voting publics, democratic governments have to be willing to fight the financial markets and understand it as a fight. When the big banks and hedge funds are wrecking the world financial system, as in 2008, or forcing European governments into fiscal austerity programs that are pretty much the diametrical opposite of what is needed to put their economies into a sustainable expansion and begin to address the very serious problem of unemployment, the financial markets really do have different immediate interests and priorities than the needs of the public in the countries affected by the markets' misbehavior and failures.


It's not a matter of greed or personal evil on the part of those running the financial institutions, though there is a great deal of the former and no shortage of the latter. As long as it's legal and feasible for financial companies to create financial derivatives that allow them to place what amount to pure gambling bets on the future course of the prices of public bonds, investment banks and other investors are just doing their jobs when they find ways to make money off that activity. And they have a real interest in doing so. For public companies, they are obligated by law to maximize their own share values to the shareholders. And under the prevailing ways the stock market functions, especially on the US exchanges, that put a very heavy emphasis on showing constant profit improvements every quarter.

When those normal and legal functions, as well as illegal actions by major financial players, seriously threaten the public interest, its the job of democratic governments to protect the public's interest against the actions of the financial markets. And to the extent that doing so threatens to restrict the ability of those markets to keep making money on deals that damage the public interests, it really is a clash of interests. The financial markets play it that way, as the recent euro crisis showed dramatically. The big problem, maybe the key problem of European and American democracy at this moment, is that the democratic governments have been far more inclined to do the bidding of the financial markets rather than to do their own jobs and protect the public interest.

A big range of solutions are being discussed and even enacted at this point. A "Tobin tax" on securities sales designed to make short-term trades less economically attractive is one of the best ones being discussed. So is banning certain kinds of derivatives.

Palme points out that under the new European emergency fund and the measures being taken by the EU, like buying up national bonds and holding them in the EU's accounts, are not nearly enough to prevent the bond vigilantes from make another strike on the public bonds of European democracies and coming back to the taxpayers yet again for even more assistance. At some point, the bonds from at least Greece will have to be adjusted so that the owners take a "haircut", i.e., lose part of the value of their principal. When that prospect becomes more imminent, there is every reason to think that the bond vigilantes will pull a similar operation to this year's.

To put it more succintly, the EU has to get the financial markets enough under the control of democratic government to prevent such raids like this. In 2010, we're seeing the financial markets (among which many of the biggest players are US and British) pummel the European democracies into austerity measures that are directly harmful to the economic interests of those countries and the world economy as a whole. It shouldn't work like this.

Part of changing that situation is for democratic governments to break their minds out of the neoloberal idolatry of the "free market", the ideology that bears heavy responsibility for getting us to this situation. And to the extent those measures restrict economic growth or even push it into decline - which in Greece is about as certain to happen as any future development in these matters can said to be certain - it will worsen the debt situation. Which is heavily influenced by basic algebra. When the economy grows, the percentage of debt to GDP goes down in the normal case. If the economy shrinks, the debt-to-GDP ratio gets larger, that is, worse. Under the conventional wisdom now in the saddle even among left government like Spain's, that rising debt-to-GDP ratio would require further cuts in national budgets, which increase the risk they will damage growth and thereby worsen the ratio even more. This would not be a virtuous cycle.

Palme also makes an important point that all democratic parties should be pounding home to their publics. According to the financial assumptions on which neoliberalism is based, a collapse like 2008 or the need for an EU bailout for holders of Greek debt wouldn't and even couldn't happen. In theory, the magic of the markets incorporates all available information about the situation of a stock or bond equally into the consciousness of every investor. Risk is managed by the prices at which the securities are traded and by holding diversified investments. If things really worked that way at the system level, neither the 2008 crash or the 2010 dive of Greek and some other European public bonds prices would have happened, and the bailouts wouldn't have been needed.

But in the real world, we've had Goldman Sachs helping Greece to hide their true level of debt from the supposedly fully-informed magic Free Market. We've had rating agencies that were cranking out bogus recommendations and acting in practice to enable high-risk speculation. We've had exotic securities that grotesquely over-valued high-risk mortgages, securities so complex than virtually no one can understand their particular risks, much less every investor in the market. We've had financial institutions that could perfectly legally create and sell securities they didn't even own and securities that were essentially nothing more than pure gambling bets.

And those financial disasters happened and those bailouts were necessary.

The financial geniuses that gave us this mess and that run the banks and hedge funds are no more capable of cleaning this up on their own than BP has been able to clean up their huge oil disaster in the Gulf of Mexico. (Or even, as of this writing, to plug the leak.) It needs to be done. The necessary restrictions will have to be enacted by the responsible governments. And the power of the financial markets to batter whole countries, already seen in the 1990s in countries like Argentina, Mexico and Indonesia, is clearly strong enough to do the same kind of thing to the wealthiest democracies, including the United States. Democracies just flat-out need to gain more power to sucessfully resist the attacks of the financial markets. That partially means better regulations and laws. In some cases, mostly obvious in the EU, it may mean significant changes in the governing structures.

And in very many cases, it means that the democratic parties themselves have to shake off the idolotry of the magical Free Market and start defending their people effectively against the financial buccaneers. As Thomas Fricke puts it, referring to the attack on Spanish and Portugese bonds that happened this year, "A spiral of skepticism, speculation attack and panic selling can only be stopped when no doubt remains that the governments will hold out against them."

In the short term, that would mean rejected the austerity measures demanded by the bond vigilantes and focus of creating jobs with the assistance of expanded public outlays. It's very sadly the case that the prospects are currently moving heavily in the high-risk direction of slashing public outlays instead.

Related articles:

Jacques Delpla, The Blue Bond Proposal Bruegel Policy Brief 2010/03 (May 2010)

Thomas Fricke, Vom Kasino in die Anstalt Financial Times Deutschland 12.02.2010. (Also here.)

Thomas Fricke, Crash mit Selbstauslöser Financial Times Deutschland 29.04.2010

Liselotte Palme, Helmut Kohl revisited: Liselotte Palme über das Ende des EU-Stabilitätspaktes Format 18.02.2010

Liselotte Palme, Die EZB hat ihre Unabhängigkeit geopfert: Liselotte Palme über die Krise des Euro Format 20.05.2010

Liselotte Palme, Die Märkte sind gaga Profil 21.05.2010

Tags: european union, financial system, us economy

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